Operating Leverage: A Framework for Anticipating Changes in Earnings

Operating leverage measures the change in operating profit as a function of the change in sales; i.e. when the company’s EBIT margin increase more than increase in revenue, company have operating leverage

Operating Leverage = Change in EBIT (%) / Change in Revenue (%)

Operating leverage means an increase in cost is lower than the increase in revenue

Basics of operating leverage (link)

One decent way to think about operating leverage is the ratio of fixed cost to variable costs; this ratio, the higher the better, because more the fixed cost (on variable cost), more the company can increase its revenue on the same fixed cost;

Example:

Here’s the example of operating leverage of the company, the variable cost is increased by 20% along with 20% increase in sales, but with no increase in fixed cost, total cost stood at 14% increase only; which eventually boost company’s profit (provide the increase of 33%)

Here is 2019, the company’s fixed cost / variable cost is 33%

In another company, the ratio is 67%, which is making its total cost increase lower (11% rather than 14%) and is also boosting its profit with more pace

A higher ratio will also cause more trouble in slowdown time

Higher fixed asset to total asset indicates higher operating leverage

Line items to analyze operating leverage

Sales growth

  1. The very first factor to forecast industry sales growth is industry growth, and there, first, lookout should be where the industry is in its life cycle called ‘the S-curve’
    One common analytical mistake is to extrapolate high growth in the middle or peak of an S-curve
  2. Merger & acquisition generally need more analysis, as it can change a company’s nature of operating leverage; though it is challenging to create substantial value through M&A
  3. There is a positive correlation between market share within industry and profit; hence change in market share become an important factor in sales growth forecasting

Sales growth is the value driver for companies only when the company earns a rate of return more than the cost of capital; if the company can’t generate economic profit (return earn – the cost of capital), it is destroying its value

The threshold margin is the level of operating profit margin at which a company earns its cost of capital

A company with higher capital intensity requires a higher operating profit margin – to reach the threshold margin – than a company with lower capital intensity

Hence, the threshold margin connects sales growth, profitability, and value creation

Value factors

Sales changes can have varying effects on operating profit margins; Analysis of the value factors, including volume, price and mix, operating leverage, and economies of scale, will allow you to sort out causes and effects

  • Volume – company’s volume changes lead to sales changes and can affect operating profit through operating leverage and economy of scale
  • Price & mix – the most important decision in evaluating a business is “pricing power”; if a company can sell its goods at a price more than its incremental cost, margins will rise;
    One can analyze pricing power by Price elasticity, i.e. if a company’s goods are inelastic – there will be no or minor change in demand due to a change in price – the company has pricing power.

Margin allows companies to increase their operating profit margin without or less increase in volume

  • Operating leverage – businesses have to spend for their future production, called pre-production cost, which is capitalized by the company; this cause lower operating profit margins in starting phase, but with an increase of capacity utilization and volume, it swings operating profit margins upward (Capacity utilization and operating profit margin have positive correlation)

Capacity utilization is the way to assess operating leverage

  • The economy of scale – the company has the economy of scale when it gets its cost lower with an increase in volume

Operating leverage is there when the company’s fixed cost gets spread among increased units

But the economy of scale is there when a company can get a better price from its supplier due to high volume

  • Cost efficiencies – Cost efficiencies can also affect operating profit margin but are unrelated to sales changes; A company can either reduce costs within an activity or can reconfigure its activities
  • Financial leverage

Financial leverage means the proportion of debt in the company’s total assets

The company’s operating profit and financial leverage determine its earnings volatility (because financial leverage generates interest liability, which acts as a fixed cost)

Financial leverage makes a company’s earnings more volatile, as it decreases earnings at a faster speed when there is a downturn

Company A and B have the same operating profits in 2018 & 2019, both company’s operating profit is falling by the same amount

Company A who don’t have any debt, get a 50% fall in its EBT with a 50% drop in operating profit

But company B gets a 71% drop in its EBT with the same drop in operating profit, due to its debt (interest payment, which act as fixed cost)

Credit rating is a good proxy of financial leverage; high ratings indicate high margins, low amount of debt (financial leverage) & strong interest expense coverage ratio

Threshold margin

Threshold margin is breakeven or minimum operating profit margin for the company, which it needs to earn to maintain its shareholder’s value; that means, threshold margin is the level at which the business will earn its cost of capital

Threshold margin can be taken in two ways

  1. Minimum margin required on incremental sales
  2. Minimum margin required on total sales

Incremental threshold margin:

Let’s say we got a 6% incremental threshold margin by this formula; that means operating profit more than 6% will create value for shareholders; that means 6% is breakeven operating profit margin on total sales for the company

Threshold margin:

Threshold margins increase as the cost of capital and incremental investment requirements increase. After all, riskier and capital-intensive businesses will need to achieve higher operating profit margins before they can expect to be creating value

When a business is operating at the threshold margin sales growth does not create value Threshold margin is breakeven for shareholder’s value creation;

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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